Tuesday, November 08, 2005

How the U.S. Can Still Run a Investment Income Surplus

One of the more surprising economic facts is that the United States still run a investment income surplus. That is, Americans receive more in interest, dividends and profits from abroad than non-Americans receive from America. After having run hugh current account deficits for more than two decades now and having therefore obtained a multitrillion dollar net foreign liability one would have expected America to run a large deficit in investment income. Since non-Americans have so much more assets in America than America have abroad then clearly America "should" run a large investment income deficit.

Equally surprising is that the investment income surplus have barely fallen in recent decades. While relative to GDP, the investment income surplus have fallen from the more than 1% of GDP it was at in the early 1980s when the U.S. started regularly running large current account deficits, it was in 2003 in nominal terms actually twice the 1980 level. And while the surplus fell somewhat in 2004 and continued to fall during the first falf of 2005 it eas even during the second quarter of 2005 at a higher level in nominal terms than in 1980 or 1998.

How can this seeming mystery be explained? The explanation is that Americans invest much smarter. At year-end 2004 , American assets abroad were $10 trillion versus foreign assets in the U.S. of $12.5 trillion. Yet as the average yield on for American investors were 4.2% versus 2.9% for foreign investments in the U.S., Americans received $415 billion in investment income from abroad versus the mere $362 billion for foreign investors in the U.S.

In what way are Americans smarter investors, then? Well, by to a much higher extent investing in stocks and direct investments than the non-Americans who invest in the U.S. Of the $10 trillion of U.S. foreign assets some 58% are either direct investments or stocks. By contrast, of the $12.5 trillion in assets that non-Americans have in the U.S. , only 37% are direct investments or stocks . The result is that with regards to ownership of business, America have more assets abroad than foreigners have in the U.S., $5.8 trillion versus $4.6 trillion.

And as a rule, ownership of business yield a lot more than bonds and other interest yielding holdings. Bonds are simply a much worse investment than equities. The total implicit yield (including retained earnings) in equities tends to be something like 7% at today's P/E ratios, much higher than bond yields. And direct investments often produce even higher yields than equities.

Indeed, the irrational foreign apetite for fixed income securities is so great that not only does this cover the U.S. current account deficit, it also enables Americans to "recycle" money they get by issuing bonds for foreigners and invest them in businesses in the home countries of the foreigners, creating large gains for Americans who pay 4% in interest yet receives 7% or more in yields from business ownership.

Why are foreigners allowing themselves to get screwed this way through their irrational preference for bonds? To some extent it might just be a case of greater timidity and risk-aversion.

Another explanation may be fear of provocing a protectionist backlash in the U.S. Americans don't mind if foreigners subsidize their consumption by buying low-yielding bonds, but they get upset if foreigners buy American companies. Case in point were the hysterical reactions to the Japanese purchases of Columbia Pictures and Rockefeller Center around 1990 and the anger over the bid for U.S. oil company Unocal from Chinese oil company CNOOC. As the Asians reckon that export income is more important for their economy than higher investment returns, they abstain from buying American companies.

Similarly, Asian central banks have been pouring in money into U.S. government bonds to keep their currencies cheap. Of the $2.5 trillion in U.S. foreign net liabaility, $2 trillion represents foreign central bank holdings of U.S. government bonds and other interest yielding assets (By contrast, U.S. government assets abroad were "only" $190 billion).

As long as Asians continue to fear stronger currencies or outright protectionist measures, they will continue to squander some of the money they make from exports to America and allow Americans to make arbitrage profits by "recycling" the money into higher yielding foreign investments.

In the short term, the U.S. investment income surplus should fall now after actually having risen between 1998 and 2003. Both as a result of continued U.S. current account deficits and as aresult of higher U.S. interest rates. The longer-term outlook is more uncertain. The large current account deficit "should" mean that the surplus should soon be turned into a deficit. Remember, with a mere 4% interest rate on the annual current account deficit of $800 billion, this means that the 2004 surplus of $53 billion "should" be eradicated by 2006. But this might take a lot longer if Americans on a aggregate level continue their smart strategy of "recycling" the money that foreigners put into low-yielding U.S. bonds.

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